ACC 331 assignment paper

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Question 1


a) Creating fictitious inventory by adding false count sheets to the inventory count.

b) Bringing sale for the first 10 days of the subsequent year forward

c) Postponing recognition of supplier’s invoices until the subsequent period

d) Creating false claims for credit on goods returned and volume discounts that had been supposedly agreed to by suppliers


Method procedures Account(s) affected U/O Assertion(s) Audit
a) inventory account O existence observing inventory to verify existence and amount
b) net sale O cut-off collecting independent confirmations from external parties (e.g., bank confirmation)


c) account payable U cut-off, obligation evaluating internal control
d) account receivable O existence observing the sale to verify existence and amount


*The scenario a) by creating fictitious inventory will affect the “inventory account”, and because this situation is based on the transaction to add the false count sheets to the inventory count, therefore it would be an overstatement.


*The scenario b) by bringing sale for the first 10 days of the subsequent year forward will affect the account of “net sale”, and it will be an overstatement of the sale.


*The scenario c) by postponing the recognition of supplier’s invoices until the subsequent period would affect the account of “account payable” and it is obviously an understatement.


*The scenario d) by creating false claims for credit on goods returned will affect the account of “account receivable” by increasing the credit sale and it is an overstatement.



Question 2 Case study: audit planning and inherent risk


1. Identify at least 10 issues that could increase the inherent risk of material misstatement

2. For each issue identified, explain why they require special attention

3. Audit procedure to address the risk


Issue no.1 Heavy capital expenditure in the manufacturing facility


Inherent risk statement


When considering the inherent risk for the auditing work, as mentioned in the case the company has in the recent years invest heavily on the factory facility, hence we can assume that the security camera like many other industries such as the chemicals, petrochemicals, oil and gas will incur great expenditure in the manufacturing facility which increase the inherent risk that may not be reflected appropriately in the financial statement.


Reasons behind the inherent risk


The heavy investment in the factory facility has two major negative impacts over the business and to the company: on one hand, though the heavy investment will increase the digit shown in the asset account, but it will certainly reduce the cash flow and ability to repay the short term debt; on the other hand, the heavy expenditure will reduce the profit that could be attributable to the shareholders.


Audit procedure to address the inherent risk


To ensure that the expenditure in the manufacturing facility is real and completely reflected, observing assets to verify existence and amount in the relevant fixed assets would be very helpful to achieve this goal though it can not solve this risk fundamentally.


Issue no.2 The industry is competitive


Inherent risk statement


When the industry is more competitive or highly competitive, the inherent risk will be increased.


Reasons behind the inherent risk


The highly competitive industrial environment will increase the inherent risk because the environment is competitive and the business activities in response to the competition would be frequent and the revenue and expenditure may also tend to be uncertain and thus some misstatement of material could happen. The competition led inherent risk worth special attention since it will increase the uncertainties in the accounting accounts and increase the difficulties for the auditor to judge the situation.


Audit procedure to address the inherent risk


It would be advised that the auditor may perform the substantive procedures at the end of the period to make the auditing more effective rather than that carried out in the beginning of the certain period to better reflect the changes happening in the industry and also in the company’s business activities during the auditing period. In addition, carrying out the audit procedures before the period end could also assist the auditor in resolving the issues by identifying them earlier.


Issue no.3 The industry is volatile


Inherent risk statement


Similar to the issue of competition, when the industry is volatile it will also increase level of inherent risk of the company. As mentioned in the case, exposed to the technological changes, legal changes, safety issues and other uncertainties, the industry is volatile and could be volatile which increase the inherent risk.


Reasons behind the inherent risk


The reason why this issue worth special attention is that the changing business environment would suggest that there might be increased complexity to take into consideration of all these factors and contingencies.


Audit procedure to address the inherent risk


The auditor could enlarge the extent of the audit procedures to control this inherent risk. Extent refers to the quantity of a specific audit procedure to be performed ( 2006). Take the health and safety issues for the staff in the different jurisdictions in which the company operates as an example, the auditor could enlarge the extent of the audit procedures as the risk of the material misstatement increases because of the volatile industrial environment.


Issue no.4 CEO’s minimal understanding of accounting


Inherent risk statement


The competency of the management would also result in the higher inherent risk because the management could lack the professional knowledge to judge the rightness accounting practices.


Reasons behind the inherent risk


The reason why the management’s accounting competency is because the management could play an important role in the internal control over the accounting practices because of their high involvement in the business activities. And their incompetency to monitor the accounting practices could increase the auditing complexity.


Audit procedure to address the inherent risk


Test of controls could be adopted here to reduce the management’s lack of accounting competency caused inherent risk. Test of controls are the activities an auditor performs to ensure that internal procedures are effective as to both their design and operation (Gul 2007, p. 452). By assessing the control effectiveness of the management, the auditor could further decide how the other techniques such as the above mentioned enlarged extent of sampling and also timing of auditing procedures could be used to control this inherent risk issue.


Issue no.5 Issues with the company’s prior operations and auditing

Inherent risk statement


As stated in the case study, from the previous auditors we have come to know that there are issues with the previous audit which have not been corrected or exposed; this will certainly increase the inherent risk.


Reasons behind the inherent risk


The company’s prior operations and problematic auditing would certainly affect the current auditing job because some issues would continue to exist and the true reflection of them would require the exposure of the previous issues.


Audit procedure to address the inherent risk


The previous audit’s wrongdoings should be exposed and corrected in the current auditing and careful investigation and confirmation should be done before such announcement.


Issue no.6 The problematic accounting methods used for foreign earning valuation


Inherent risk statement


According to the previous auditors, the accounting methods used for the foreign currency profits and losses were not reliable and they will increase the inherent risk.


Reasons behind the inherent risk


The inappropriate method of foreign currency profit evaluation would result in articulated and false accounting practices and material misstatement. And such information would be misleading to the financial report users.


Audit procedure to address the inherent risk


A test of the effectiveness and appropriateness of the current accounting method relevant to the foreign profit evaluation should be done to see whether the information provided by the previous auditors is right or not before further reporting about such issue could be made.


Issue no.7 Obsolete stock


Inherent risk statement


A business whose inventory becomes obsolete quickly experiences high inherent risk.


Reasons behind the inherent risk


Excess or obsolete inventory refers to inventory for which the amounts on hand are excessive when considering projected sales ( 2009). Since the high risk of obsolete stock would probably make the stocks of no value, and the inventory would be overestimated, hence they should receive attentions.


Audit procedure to address the inherent risk


The audit could perform the observation of the physical inventory and at the same time refer to the professionals to decide whether the stocks are in good conditions and whether there is a high chance of becoming obsolete stock since they are made to meet the special standards.


Issue no.8 Contract restriction


Inherent risk statement


As stated in the case, the company have contract with the bank because of a bank loan in which the company is restricted to maintain a current ratio of 1.5 to 1 and a quick ratio of 0.9 to 1.


Reasons behind the inherent risk


Such restriction will have limitation over the presentation and business activities of the company.


Audit procedure to address the inherent risk


The timely auditing of the current ratio and quick ratio would be necessary.


Issue no.9 Financial difficulties


Inherent risk statement


The company faces cash flow issues in its current financial situation.


Reasons behind the inherent risk


The cash flow problem would affect the company normal business activities and ability to pay back the due liabilities.


Audit procedure to address the inherent risk


Continuous monitoring of the cash flow trend using method such as the linear regression could help avoid the sudden short term insolvency because of the lack of cash.


Issue no.10 Auditor’s reporting to top management rather than to the audit committee


Inherent risk statement


The first inherent risk is the about the reporting system. Though it is not mentioned clearly in the case, it seems that the auditor will directly report to the top management rather than the audit committee, this will increase the inherent risk. We will elaborate the reasons behind such increase of inherent risk in the following.


Reasons behind the inherent risk


It is believed that when an auditor reports to the senior management of a company who are responsible for the financial statement, it would be less likely that the internal auditor will be able to objectively perform the function (Delaney & Whittington 2010, p. 143). On one hand, the management of the company under some circumstances may require the auditor to create false auditing reports to protect the creative accounting because they tend to defend a sound financial situation since they face the pressure from the shareholder to achieve this target. Therefore if the auditor is reporting to the management directly, there could be increased inherent risk. On the other hand, to please the management who are the supervisor of the auditors, the auditors may tend to satisfy the requirements from the management.


Audit procedure to address the inherent risk


But building up of the audit committee could be a helpful way to reduce this risk. An audit committee is an operating committee of the Board of Directors charged with oversight of financial reporting and disclosure (Moeller 2010). Since the audit committee is made up by some members Board of Directors, this audit committee will tend to ensure the objectivity of the auditing work based on the interest of the shareholders.


Question 3 Analytical procedures


1. Financial ratios.


Net profit ratio= Net profit / Net sales

-0.76% -8.16% -7.14% -12.42%
2009 2010 2011 2012


Gross profit ratio= Gross profit / Net sales

11.45% 10.71% 13.16% 12.08%
2009 2010 2011 2012


Working Capital ratio=Current assets/current liabilities

83.93% 69.79% 70.83% 18.42%
2009 2010 2011 2012


Quick asset ratio= (current assets-inventories)/current liabilities

39.29% 33.33% 34.72% -14.74%
2009 2010 2011 2012


Debt to total assets ratio = Total debt/Total Assets

66.67% 91.82% 96.04% 97.56%
2009 2010 2011 2012


2. Financial analysis


Based on the above financial ratios, we can see that there are several key evidence from which we may conclude that there are worrying trends related to the company’s going concern. First of all, in term of the company’s profitability the gross profit ratio which indicates how much of each sales dollar is available to meet expenses and profits after merely paying for the goods that were sold is low and what is more the net profit ratio is even negative suggesting that the remaining profit after all costs of production and administration cost is negative which is a loss. Such loss is even enlarging in 2012 reaching a -12.42% in the Net profit ratio. Secondly in term of the solvency, as we can see from the working capital ratio which an indicator of the short term financial credibility of a company, an obvious and continual decline in the working capital ratio is actually a red flag suggesting the company may have difficulties to meet the short term liabilities. Similar scenario could also be found in the Quick asset ratio. In addition, in term of the Debt to total assets ratio, the ratio has been kept in a very high level since 2010 indicating that the company not only has short term insolvency concerns but also long term solvency is also under further evaluation and it could be problematic. In a world, there should be attentions given to the company’s going concern because of these warning trends.


3.0 Other audit techniques


Data envelopment analysis


Data envelopment analysis is an optimization method for assessing the relative efficiency of similar operational units that combine multiple resources to produce multiple results ( 2007). Because as mentioned in the case, the company has automated a lot of its major operations in year 2010, if such automation process does not obviously contribute to the business growth in term of sale and profit growth, then we may believe that the company has issues relevant to the going concern of its business.


Discriminant analysis


Discriminant analysis is a statistical method that is used by researchers to help them understand the relationship between a “dependent variable” and one or more “independent variables.” ( 2010). To identify whether the company has going concern problem or not, we can distinguish between the going concerns and non-going concerns groups. Such differentiations should be made within the industry. Finally based on the results we will be able to see whether the company’s business operations and financial situations are closed to companies with going concern issues or not.

Reference 2006. Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained. Accessed on 10 May 2012 [online]


Delaney, P. R. & Whittington, O. R. 2010, Wiley CPA Exam Review 2011, Auditing and Attestation. New Jersey: John Wiley & Sons, Inc. p. 143


Gul, F. A. 2007, Hong Kong Auditing: Economic Theory and Practice. Hong Kong: City University of Hong Kong Press. p. 452


Moeller, R. 2010. IT Audit, Control, and Security. New Jersey: John Wiley & Sons. 2010. DISCRIMINANT ANALYSIS. Accessed on 10 May 2012 [online] 2007. Data Analysis: Analyzing Data – Other Audit Techniques. Accessed on 10 May 2012 [online] 2009. Application testing. Accessed on 10 May 2012 [online]